On The Frontier, Active Management Still Going Strong

By Brendan Conway

Active fund management has taken a battering the last few years. Rightly so: Precious few stock pickers can actually beat the Standard & Poor’s 500 stock index. For the service of trailing the benchmark, they cost more, too.

But active management still holds sway in relatively inefficient frontier markets like Nigeria or Pakistan, where Citigroup’s Maria Gratsova observes in a client note this morning that 94% of investors’ $15 billion in frontier-markets funds are under active management. (The comparable percentage for emerging-markets funds is 76% and falling fast.)

The fact that Wall Street analysts spend far less time on these markets — making the do-it-yourself approach riskier — may be one reason so many investors still prefer active management. It takes skill and research to pick the winners in these far-flung countries. Not to mention that it’s tougher to piggyback when stock indexes are forced to include relatively illiquid names, and name-brand investors to mimic are scarce. And it’s not as if investors lack for passive fund options: The Guggenheim Frontier Markets ETF (FRN) and the PowerShares MENA Frontier Markets Portfolio (PMNA) have been on the market for four years.

BlackRock (BLK) is looking to change all this with the passively managed iShares MSCI Frontier Markets 100 Index Fund (FM). Launched last month, the fund attempts to do for frontier markets what the iShares MSCI Emerging Markets Index Fund (EEM) did for larger developing countries. Gratsova, for her part, is enthused at the good news of a major ETF company building a passive fund for the frontier. But she still prefers active management, for three reasons.

Benchmark construction: The index behind the new passive fund is 55% financials, which “leaves investors with an equity portfolio that feels too heavily tilted towards one sector,” she writes. If you believe in the strength of the emerging-markets consumer, you’d want to see a heavy emphasis for those stocks over financials. Whereas diversification sounds like a powerful argument in favor of the passively managed fund, look under the hood and you may find less of it than hoped for. Kuwait is 28% of the index and Gulf-area countries take a total of 55% of the exposure. If you like Southeast Asia, Latin America or sub-Saharan Africa, you probably want to see less of the Gulf.

ETF inefficiency in small and microcaps: Gratsova notes that the median market cap of countries in the MSCI frontier-markets index is $1.1 billion, or just $390 million on a float-adjusted basis. What if the passive ETF takes off in popularity, requiring it to own a third or half, or more of a company with $390 million in publicly available stock? (Read our story “When ETF is A Four Letter Word” for more color on such cases.)

Low free floats: A closely related problem to number two. Gratsova estimates that Jordan is the worst country in the index in this regard — just 6% of shares are thought to be free floating. Ukraine is 12% and Romania, 13%. If you need to buy big batches of these stocks, you’ll pay a premium and potentially create price distortions. Index statistical sampling strategies can only do so much to solve this problem.

Thus, conditions are still ripe for an offering like the Nile Pan Africa fund (NAFAX) to clean up — the fund is up nearly 34% this year, or nearly triple the comparable Morningstar index. This fund is tiny, with $15 million in assets, and that’s probably how you want it. While this fund charges a princely 2.50% expense ratio, let’s talk about “princely:” Compared to what, exactly? If there’s nothing truly comparable — and this case, there’s isn’t — then you know that active management may be the way to go.

About Emerging Markets Daily

Emerging markets have been synonymous with growth, but the outlook for individual nations is constantly changing. Countries from Brazil and Russia to Turkey face challenges including infrastructure bottlenecks, credit issues and political shifts. The Barrons.com Emerging Markets Daily blog analyzes news, data and research out of emerging markets beyond Asia to help readers navigate the investment landscape.

Barron’s veteran Dimitra DeFotis has been blogging about emerging market investing since traveling to India and Turkey. Based in New York, she previously wrote for Barron’s about U.S. equity investing, including cover stories and roundtables on energy themes. Dimitra was among the first digital journalists at the Chicago Tribune and started her career as a police reporter at the Daily Herald in the Chicago suburbs. Dimitra holds degrees from the University of Illinois and Columbia University, where she was a Knight-Bagehot Fellow in the business and journalism schools.